FTX I

Crypto’s Lost Vision: Breaking Down the FTX Scandal

“It also offers a lesson: the world’s recent obsession with knighting these quirky kids and holding them up as standard bearers simply because what they do seems complex is not wise. And worse, it’s directly contradictory to the original ethos of the space.”

A scandal in the cryptocurrency universe erupted last week, causing a once-vaunted and widely admired cryptocurrency exchange and trading firm to go belly-up in a matter of days. Judging by the media reaction, one might think this is the first time the industry has experienced a high-profile bankruptcy.

But crypto-land has seen this before. In 2014, a highly popular but poorly run Bitcoin exchange called Mt. GOX—an acronym for Magic the Gathering Online Exchange—similarly failed in spectacular fashion. Many early bitcoin adopters were effectively robbed of their funds, and Bitcoin slumped into a protracted bear market for several years. Just this year, in fact, the crypto market has seen collapse after collapse. The Terra Luna crash and Celsius implosion, for example, saw major sell-offs and a rapid (largely unsuccessful) scramble by users to secure the cryptocurrency they held with these organizations. 

The FTX scandal sweeps more broadly than any prior industry collapse because its investors comprised many elite players from the traditional finance and political classes. FTX was seen as a safe way to gain exposure to cryptocurrency without having to invest in the volatile market directly. And these beliefs were uncritically confirmed by a fawning media that spent much of the last year knighting FTX’s now-disgraced founder, Sam Bankman-Fried.

As someone who has been in the Bitcoin space for quite a while now, the mainstream obsession with SBF, as Bankman-Fried is commonly known, never made much sense. In July, responding to Anthony Scaramucci’s praise of a New York Times puff piece on SBF, I noted the probable demise of such a seemingly astroturfed campaign to elevate this unproven kid to godlike status (forgive the salty language, it’s Twitter).

100% agree. And the elite media obsession with SBF is cringe and will only end badly

— Bryan Jacoutot (@BryanJacoutot) July 19, 2022

Four months later, FTX is in bankruptcy. People who held their money and cryptocurrency with the formerly respected exchange have had their accounts frozen. And its founders, including SBF, are in hiding in the Bahamas, apparently contemplating fleeing to Dubai, a non-extradition treaty country.

As best as we can tell so far, here’s what happened. 

SBF catapulted to prominence by inventing a trading algorithm that essentially arbitraged the price of Bitcoin (and presumably other cryptocurrencies) across domestic and foreign exchanges. As one (now remarkably embarrassing) YouTube expose on SBF put it: If Bitcoin were priced at $10,000 on a U.S. exchange and $11,000 on a Japanese exchange, SBF’s algorithm would essentially buy the $10,000 Bitcoin in the U.S., then sell it for $11,000 in Japan and pocket the difference.

Arbitraging is nothing new, but apparently, the margins were quite good for SBF, who would go on to found a quantitative trading firm Alameda Research, in 2017 using these tactics. But that was not enough for SBF, the self-described “effective altruist,” who wanted to make billions purportedly so he could just “give it away.” So in 2019, he decided to spin off his own cryptocurrency exchange, which he would call FTX. Importantly, this exchange created its own cryptocurrency token, FTT, which could be used to secure discounts on trades and grant access to other incentives unique to the FTX trading experience. It also traded on the secondary market, and people would buy and sell FTT in hopes that its value would rise along with FTX.

The creation of FTT and the subsequent reliance of Alameda Research on the token would prove crucial to SBF’s downfall.  But before we get to the fall, let’s explore the rise.

In 2021, amid an incredible cryptocurrency bull market, FTX started raising money. A lot of it.

That July, FTX raised $900 million at a valuation of $18 Billion. And more capital raises occurred throughout the year, with FTX’s valuation eventually ballooning to $25 Billion.

Despite the cooling off of the market in 2022, the first half of the year was no different. In January, FTX raised an additional $400 million from SoftBank at a valuation of $32 Billion. (SoftBank, you may recall, was an early investor in WeWork, which also spectacularly crashed before an IPO listing in no small part because of the founder’s extravagant spending and investments).

Things appeared to be going great for FTX as it inked a $135 million sponsorship deal for naming rights of the Miami Heat’s home court. But the fragile cryptocurrency market was faltering. As prices started falling, many companies built around these currencies were going defunct. First, it was the Terra Network, which took Three Arrows Capital, a hedge fund giant, down with it. Then crypto bank Celsius experienced a bank run and could not cover its obligations. It is now in bankruptcy proceedings.

Amidst all this turmoil, FTX and Alameda Research– fresh off years of capital raises amounting to billions of dollars — appeared poised to pick through the wreckage. On July 22, 2022, FTX executed a partial bailout of Voyager Digital, a publicly traded company steeped in the cryptocurrency space. It also spent $250 million to prop up crypto lender BlockFi, which promises above-market APY returns if you park your cryptocurrency with them.

Perpetually incorrect investment analyst, Jim Cramer, summed up the general belief of Traditional Finance players that SBF was crypto’s white knight:

Sam Bankman-Fried doles out credit lines to save crypto institutions. He's the new JP Morgan!

— Jim Cramer (@jimcramer) June 22, 2022

And while SBF was consolidating his market share in crypto with one hand, he used the other to acquire political capital. As Alex Berenson points out, SBF spent roughly $50 million donating to Democrats in 2020 and 2022, apparently making him the second largest donor to Democrats behind only George Soros.

2/ Fun fact 4: This may be the biggest loss investors in a fund/broker suffer since the Bernie Madoff collapse, but outside the financial media it has received almost no attention.

Fun fact 5: SBF’s ties to the Democratic Party have received even LESS scrutiny…

— Alex Berenson (@AlexBerenson) November 12, 2022

SBF didn’t want to quit there. In fact, he had aspirations of donating up to $1 Billion to political causes over the next few years. But the gravy train would soon run out.

On November 2, 2022, nearly one year from the cryptocurrency market’s high water mark, a copy of Alameda Research’s balance sheet leaked. And despite all the dollars raised by SBF over the preceding 22 months, much of Alameda’s purported “assets” were in the form of FTT, the crypto token created by FTX. CoinDesk reported at the time:

Billionaire Sam Bankman-Fried’s cryptocurrency empire is officially broken into two main parts: FTX (his exchange) and Alameda Research (his trading firm), both giants in their respective industries.

But even though they are two separate businesses, the division breaks down in a key place: on Alameda’s balance sheet, according to a private financial document reviewed by CoinDesk. (It is conceivable the document represents just part of Alameda.)

That balance sheet is full of FTX – specifically, the FTT token issued by the exchange that grants holders a discount on trading fees on its marketplace. While there is nothing per se untoward or wrong about that, it shows Bankman-Fried’s trading giant Alameda rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto. The situation adds to evidence that the ties between FTX and Alameda are unusually close.

The financials make concrete what industry-watchers already suspect: Alameda is big. As of June 30, the company’s assets amounted to $14.6 billion. Its single biggest asset: $3.66 billion of “unlocked FTT.” The third-largest entry on the assets side of the accounting ledger? A $2.16 billion pile of “FTT collateral.”

There are more FTX tokens among its $8 billion of liabilities: $292 million of “locked FTT.” (The liabilities are dominated by $7.4 billion of loans.)

“It’s fascinating to see that the majority of the net equity in the Alameda business is actually FTX’s own centrally controlled and printed-out-of-thin-air token,” said Cory Klippsten, CEO of investment platform Swan Bitcoin, who is known for his critical views of altcoins, which refer to cryptocurrencies other than bitcoin (BTC).

And with that revelation, a chain reaction was set off. As news of the leak spread, holders of large sums of FTT began wondering why they had exposure to a cryptocurrency that essentially acted as a bridge loan for SBF’s trading fund. One player in particular executed the death knell for SBF: Chengpeng Zhao (or CZ as he is commonly called).

As part of Binance’s exit from FTX equity last year, Binance received roughly $2.1 billion USD equivalent in cash (BUSD and FTT). Due to recent revelations that have came to light, we have decided to liquidate any remaining FTT on our books. 1/4

— CZ Binance (@cz_binance) November 6, 2022

CZ is the CEO of Binance, the world’s largest crypto platform. And reports of his rapid liquidation of FTT precipitated a generalized market sell-off of the token. What’s worse, the Wall Street Journal reported that SBF was using customer deposits on FTX for loans to cover Alameda Research’s risky bets. With FTT having lost roughly 95% of its value in just over a week, it is likely that most customer deposits will never be returned.

As of now, SBF has resigned, and FTX has entered bankruptcy proceedings. The WSJ reported this morning that SBF is now “in the crosshairs” of U.S. prosecutors.

The situation is a stark reminder of the fragility of the cryptocurrency space and the risk associated with entering it. It also offers a lesson: the world’s recent obsession with knighting these quirky kids and holding them up as standard bearers simply because what they do seems complex is not wise. And worse, it’s directly contradictory to the original ethos of the space.

Bitcoin, the world’s first cryptocurrency (and the only viable one to my mind), was created on the premise that users should corroborate for themselves the state of the protocol. As it is often put in Bitcoin circles, “don’t trust, verify.” That’s why the Bitcoin blockchain is public. And that’s why if you take the responsibility of controlling your accounts (instead of handing that responsibility to these fragile exchanges), you are able to send value all over the world instantly and without permission.

This culture is embedded in Bitcoin’s creation. Just after publicly releasing the code for Bitcoin, pseudonymous creator Satoshi Nakamoto put its purpose squarely into view.

The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.

For its part, Bitcoin has–through much discipline and more than a few internal fights–retained all the attributes that Satoshi found lacking in traditional currencies. But the cryptocurrency space at-large has spent year after year rediscovering all the problems associated with traditional currencies. It appears almost entirely based on trust, and it’s increasingly clear that untrustworthy people largely lead it.

If Bitcoin was designed to avoid the problems of legacy finance, crypto appears equally designed to readopt them.

In the first bitcoin block ever mined, known as the Genesis Block, Satoshi placed a coded reference to the problem of trust in currencies and the requirement of bailouts that inevitably follow when such trust is abused. Because it was a newspaper headline, the message partially operates as a timestamp to indicate that the chain kicked off on that particular date. But it was also perhaps an effort to communicate that Bitcoin would work differently than the system that led us to that crisis.

The Times 03/Jan/2009 Chancellor on brink of second bailout for banks

Nevertheless, CZ just revealed a possible rescue package for future faltering crypto companies and banks

To reduce further cascading negative effects of FTX, Binance is forming an industry recovery fund, to help projects who are otherwise strong, but in a liquidity crisis. More details to come soon. In the meantime, please contact Binance Labs if you think you qualify. 1/2

— CZ Binance (@cz_binance) November 14, 2022

What could go wrong? In the immortal words of The Who: “Meet the new boss, same as the old boss.” (read more)